Electricity price regulation ‘superfluous’

Queensland and NSW have yet to deregulate retail electricity prices, although they are under pressure from the Commonwealth to do so. There seems to be sufficient retail competition in south-east Queensland to warrant deregulation, but the state government is unwilling because a lack of competition in regional Queensland prevents a state-wide move.

Retailers in south-east Queensland offer market customers substantial discounts from the regulated prices, suggesting it is competitive pressures, not the regulator, that determine retail prices. Nevertheless, the retailers continue to complain that the Queensland Competition Authority is setting regulated prices too low. Why do they care?

The most vociferous complaints have come from
Origin Energy
, which recently failed in a Supreme Court action for Judicial Review of the QCA’s 2012-13 price determination. The particular focus of Origin’s complaints was the QCA allowed energy costs to reflect current expectations about NEM wholesale prices.

Origin’s view seems to have been that the energy-cost allowance in regulated retail prices should be sufficient to allow Origin Retail to make a substantial contribution to the sunk costs of Origin’s past generation investments in every year.

The price that Origin Generation actually receives in any year for the electricity that it generates is the NEM wholesale price. This can be insufficient to cover a generator’s historical average costs for two reasons. The first is cyclical – in some years NEM prices might be low, making a relatively small contribution to the generator’s costs. But in other years prices will be higher and overall the generator’s costs can be recouped. The second reason is that the generator’s investment decision might turn out not to be justified by market outcomes. That is, actual market conditions might prove systematically inferior to the assumptions underlying the investment decision. This is a risk the generator takes on when it makes its investment and for which the shareholders of the company are rewarded by the cost of capital built in to the investment decision. In a well-functioning market economy, it would be the shareholders who suffer if things turn out badly, not electricity consumers.

In deregulated markets such as Victoria, competitive pressures are inhibiting retailers from raising prices to levels that they would like. This is exactly what one would expect when retailers who are unencumbered by generation assets have opportunities to access power at relatively low wholesale NEM prices. Hence it seems that the QCA’s determination is doing little more than aping the competitive pressure that Origin would face if the Queensland retail market were deregulated –as it probably should be. With evidence of competition in the retail electricity market in south-east Queensland, the main complaint one could make about the QCA’s role is that it is unnecessary, not that it sets prices too low.

Notwithstanding the substantial discounts against regulated prices that competition is forcing Origin to offer customers in south-east Queensland, there is one sense in which Origin might benefit from higher regulated prices. It retains a rump of customers who remain on regulated prices, despite the fact that they could access substantial discounts were they to move to market contracts. Hence, high regulated prices offer a free kick to the large retailers who account for most of the minority of customers who remain on regulated prices.

Still, Origin should be careful what it wishes for. Higher regulated prices would have little or no effect on customers who are already on market contracts, but it would most likely increase the rate at which the rump of customers abandons regulated prices for market contracts.

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The problem underlying Origin’s decision to take legal action against the QCA might well be that current wholesale electricity prices and those now expected to prevail in the future are insufficient to recoup the sunk costs associated with Origin’s past generation investments.

The financial market might conclude that taking legal action against the Queensland regulator was another bad investment decision. Origin shareholders could still benefit if the experience makes Origin’s management refocus on its decision-making processes rather than blame the regulator. In responding to the Supreme Court decision, Origin has said that it will “work with all levels of government to support a sustainable energy market". Applying pressure to political decision makers is a common business strategy.

In the meantime, the QCA will make its 2013-14 retail price determination knowing that its preference for allowing regulated retail prices to reflect current forecasts of wholesale prices will not run foul of the law.